Example of Capital budgeting

 Before we start the NPV calculation, here are the facts we are going to use –

·       The cost to install the required equipment will be $105,000, this is the outflow on year 0, this is a tangible long term asset, and we are going to depreciate it over 5 years in a straight line, so it will depreciate at the rate of $21000 every year until the book value becomes 0

·       The gross revenues from the project will be $25,000 for year 1, then $27,000 for years 2 and 3. Year 4 will be $28,000 and year 5 (the last year of the project) will be $23,000·     

·       The estimated cash outflows are $13000 on year 1, $12000 on year 2 to 4 and on 5^th year $10000

·       In 5 years, the equipment will stop working and can be sold for its parts for about $5,000.

·       The capital borrowing cost is 3%

·       Discount rate we will use to calculate NPV 7%

 With these data we can calculate the net income from the project considering all cash inflows and cash outflows -

Year	0	1	2	3	4	5	5
Project Discount Rate	0.07
Equipment purchase price	($105,000)
Cash inflow from new equipment		$25,000	$27,000	$27,000	$28,000	$23,000
Salvage value							$5,000
Depreciation		($21,000)	($21,000)	($21,000)	($21,000)	($21,000)	$0
Interest Payment on Loan		($3,150)	($3,150)	($3,150)	($3,150)	($3,150)
Outflow		($13,000)	($12,000)	($12,000)	($12,000)	($10,000)
Earning Before Tax		($12,150)	($9,150)	($9,150)	($8,150)	($11,150)	$5,000
30% Income Tax							$1,500
Net Income	($105,000)	($12,150)	($9,150)	($9,150)	($8,150)	($11,150)	$3,500

In the table above we have considered the gross revenue (estimated) to the estimated cash inflows and the salvage value of the equipment to be cash inflow too.

Depreciation is considered as a deduction from revenue before tax (Investopedia, n.d.)

The $105000 was borrowed and we will have to make an interest payment at interest rate 3%, that is considered as cash outflow.

And we have to factor in the project cash outflows over 5 years period.

So, we can see in the above table the Income before tax is in negative, so the income tax won’t be applicable on those, apart from the cash the business generates for the salvage value of the equipment.

We can calculate the Operating Cash flow, just by adding the depreciated value back to net income

Year	0	1	2	3	4	5	5
Project Discount Rate	0.07
Equipment purchase price	($105,000)
Cash inflow from new equipment		$25,000	$27,000	$27,000	$28,000	$23,000
Salvage value							$5,000
Depreciation		($21,000)	($21,000)	($21,000)	($21,000)	($21,000)	$0
Interest Payment on Loan		($3,150)	($3,150)	($3,150)	($3,150)	($3,150)
Outflow		($13,000)	($12,000)	($12,000)	($12,000)	($10,000)
Earning Before Tax		($12,150)	($9,150)	($9,150)	($8,150)	($11,150)	$5,000
30% Income Tax							$1,500
Net Income		($12,150)	($9,150)	($9,150)	($8,150)	($11,150)	$3,500
OCF		$8,850	$11,850	$11,850	$12,850	$9,850	$3,500

Taxes are included while calculating operating cash flow, but depreciation is added first to the revenue and then tax is subtracted (Investopedia, 2018). But in this case the company is not making any profit before taxes. Since the company is making loss there won’t be any tax on losses.

Now that we have Cash Flow, we can estimate the Present Value and Net Present Value -

Year	0	1	2	3	4	5	5	NPV
Project Discount Rate	0.07
Equipment purchase price	-105000.00
Cash inflow from new equipment		25000.00	27000.00	27000.00	28000.00	23000.00
Salvage value							5000.00
Depreciation		-21000.00	-21000.00	-21000.00	-21000.00	-21000.00	0.00
Interest Payment on Loan		-3150.00	-3150.00	-3150.00	-3150.00	-3150.00
Outflow		-13000.00	-12000.00	-12000.00	-12000.00	-10000.00
Earning Before Tax		-12150.00	-9150.00	-9150.00	-8150.00	-11150.00	5000.00
30% Income Tax							1500.00
Net Income		-12150.00	-9150.00	-9150.00	-8150.00	-11150.00	3500.00
OCF		8850.00	11850.00	11850.00	12850.00	9850.00	3500.00
Present Value of Future Cash Flow	-105000.00	8271.03	10350.25	9673.13	9803.20	7022.91	2495.45
NPV								-61854.88

Hence the NPV the negative, so this project is not financially profitable.

Conclusion – based on the NPV which is negative this project should not be pursued.

References:

Retrieved on 4/29/2018. Retrieve from https://www.investopedia.com/terms/n/npv.asp

Retrieved on 4/29/2018. Retrieved from https://www.investopedia.com/terms/i/irr.asp

Retrieved on 4/29/2018. Retrieved from https://www.investopedia.com/ask/answers/012615/are-taxes-calculated-operating-cash-flow.asp